Why You Shouldn't Rely on These Dividend Stocks

Investors are facing one of the toughest challenges they've ever had to deal with. With interest rates at rock-bottom levels, it's really hard to generate the income that many people need in order to make ends meet.

As a solution, many investors have decided to embrace dividend-paying stocks in lieu of bonds and other fixed-income investments. In a booming stock market, that's been a winning bet. But in the process, retirees and other conservative investors are adding to their risk levels -- and eventually, those bets could come crashing down on them, creating what could become a new financial crisis.

In search of cash
In this month's brand new issue of the Fool's Rule Your Retirement newsletter, which is available today at 4 p.m. EDT, Foolish retirement expert and financial planner Robert Brokamp takes a closer look at how investors are piling into dividend stocks. Not only are interest rates on bonds unattractive, but investors are also concerned about the potential for capital losses even on ultra-safe Treasury bonds, as rising interest rates in the future could take a bite out of bond values.

My colleague John Rosevear argues that dividend stocks are simply the best way to get the income you need. But before you accept his argument, let's take a look at how investing in dividend stocks can go horribly wrong -- and end up putting you in an even worse financial situation.

Dividends aren't forever
Investors need steady, reliable income in order to plan their finances. The benefit of bonds is that no matter how much or how little they pay, you know in advance exactly how much you're going to receive and when you're going to get it. Barring a cataclysmic event like a default, a bond's payouts are reliable and dependable.

By contrast, dividends from stocks are inherently unpredictable. Although that lack of predictability sometimes results in positive surprises when dividends increase, companies have no legal obligation to keep paying dividends at all, leaving the door open to dividend cuts at any time.

That's a lesson that all too many investors learned the hard way three years ago. Back then, dividend stalwarts General Electric (NYS: GE) and Dow Chemical (NYS: DOW) made big dividend cuts of 60% to 70%. Accompanied by the huge share-price drops during that period, shareholders who relied on what had previously been attractive dividend yields got a nasty reminder of how risky stocks are.

Moreover, we're still seeing similar moves today. Take a look at what's happened to some of these favorite dividend stocks:

  • Frontier Communications (NAS: FTR) has been a cash cow for shareholders over the years, as it pays out the lucrative cash flows from legacy wireline telephone service revenue. But on two occasions during the past 18 months, the company has had to cut its dividend, which now stands 60% below where it was in mid-2010. The current yield of 9% may still look attractive, but with shares having lost half their value in less than a year's time, longtime investors certainly haven't gotten the results they'd hoped for.

  • Another area that income-hungry investors have looked to is the mortgage REIT sector. These companies make money on the spreads between short- and long-term interest rates and pass their profits through to shareholders, and the double-digit yields they offer are exactly what many people need right now. But Annaly Capital (NYS: NLY) already pays less than three-quarters of what it did in late 2009, and further pressure on rates could prompt future cuts. Compared to current levels of $0.55 per share in quarterly dividends, Annaly paid only $0.10 in late 2005. Chimera Investment (NYS: CIM) has seen even faster dividend deterioration, with a nearly 40% cut since late 2010. Moreover, both stocks trade at levels well below their highs of the past couple of years.

Of course, plenty of dividend stocks not only maintain payouts but raise them regularly. Yet even in those cases, a stock market swoon can create losses that conservative investors can't afford to weather.

Best of a bad lot
So if you need income, how much can you afford to rely on dividend stocks? The new issue of Rule Your Retirement gives a balanced view of both bonds and dividend stocks, helping you figure out the right mix for your portfolio. And it's available free with a 30-day trial subscription.

Even with low rates, bonds do something that dividend stocks can't: hold their value and assure repayment of principal. For most investors, that's a feature that you just can't live without.

Getting the income you need is just one element of a successful financial plan for your retirement. Our special free report highlights the shocking truth about your retirement. Don't miss this chance to grab your free copy of this can't-miss report today.

At the time thisarticle was published Fool contributor Dan Caplinger deals with the ups and downs of dividend stocks. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Annaly Capital. Motley Fool newsletter services have recommended buying shares of Annaly Capital. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy never loses value.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.